Bidding with Securities -- Auctions and Security Design

Stanford University, Stanford CA

Investigators

Abstract

In recent years auction theorists have been asked to provide guidance to policymakers in a wide range of important transactions. Current theory focuses on the case when the winning bidder pays a fixed amount at the conclusion of the auction. However, in many real world auctions ranging from broadcasting the olympic games to the rights to drill for oil or the choice of the leading counsel in a class action suit, the winning bidder pays long after the conclusion of the auction. Moreover, the payment is contingent on future events, and depends on the realized cash flows from the object being sold. In this case, the payment can be thought of as a derivative security, where the underlying asset is the future cash-flows. This proposal combines two existing lines of economic research, auction theory and security design, to study auctions in which the bids are securities rather than fixed payments. This type of auction, refered to as a security-bid auction, has a large number of potential applications beyond those given above, including major privatization auctions. Intellectual Merit: This research should advance knowledge and understanding in two major fields: auction theory and security design. This study expands auction theory in a direction that will make it more applicable to an even a larger number of markets. Preliminary work suggests that some of the fundamental results of standard auction theory with fixed payments could be modified. This study also contributes to the understanding of security design. Security design is a basic topic in financial economics. The important questions include (i) why do parties choose to divide future cash flows (and hence risks) in standard forms, such as debt and equity; and (ii) does this choice matter? While a great deal of progress has been made in answering these questions, the existing finance literature primarily considers the case of a single issuer selling a security to competing investors. The auctions examined in this study are important instances in which several issuers compete by offering securities to a single agent. An important example is that of mergers and acquisitions. In this case bidders often offer securities such as equity or preferred stocks in the merged firm. This study provides insight into the optimal choice of securities in these and other transactions. Broader Impact: This study should have useful policy implications: the results may guide practitioners regarding the design of auctions to use in different settings. For example, when bidders promise fixed payments but may default (i.e., bids are debt securities), a second-price auction results in superior revenues for the seller. However, when bidders promise a fixed payment plus a royalty rate, a first-price auction may be superior. Both examples are common in government auctions of public resources. Furthermore, this study will hopefully spur and guide more applied research focused on auction design using security bids in particular markets.